CHAPTER 11 | Long-Run Economic Growth:

Sources and Policies

Economic Growth over Time and around the World (pages 354–259)
11.1 Learning Objective: Define economic growth, calculate economic growth rates, and
describe global trends in economic growth.

A. Economic Growth from 1,000,000 B.C. to the Present

No sustained economic growth occurred between 1,000,000 B.C. and 1300 A.D. Significant growth did not
begin until the Industrial Revolution. The Industrial Revolution refers to the application of mechanical
power to the production of goods, beginning in England around 1750. Before that time, production of
goods had relied almost exclusively on human or animal power. First England, and then other countries,
experienced long-run economic growth with sustained increases in real GDP per capita.

B. Small Differences in Growth Rates Are Important

Because of compounding, in the long run small differences in economic growth rates result in big
differences in living standards.

C. Why Do Growth Rates Matter?

Growth rates matter because an economy that grows too slowly fails to raise living standards. In some
countries in Africa and Asia, very little economic growth has occurred in the past fifty years, resulting in
severe poverty.

D. “The Rich Get Richer and …”

The world can be divided into two groups: the high-income countries (or the industrial countries) and the
poorer countries (or developing countries). The high-income countries include the countries of Western
Europe, Australia, Canada, Japan, New Zealand, and the United States. The developing countries include
most of the countries of Africa, Asia, and Latin America. In the 1980s and 1990s, a small group of
countries, mostly East Asian countries such as Singapore, South Korea, and Taiwan, experienced high
growth rates and are referred to as the newly industrializing countries.

Extra Solved Problem 11.1

Economic Growth in the United States since 1929
Figure 11.1 in the textbook shows that the world’s average annual growth rate of real GDP per capita in
the period 1800 to 1900 was 1.3 percent and equaled 2.3 percent from 1900 to 2000. The Bureau of
Economic Analysis has estimated that the real gross domestic product (in 2009 prices) of the United
States in 1929 was $1,055.6 billion. The table below shows what real GDP would be for 1930 assuming
that the growth rate of real GDP was 1.3 percent, 2.3 percent, and 3.3 percent from 1929 to 1930. The
estimated values for 1930 were obtained by multiplying $1,055.6 billion by 1.013, 1.023 and 1.033,
respectively.

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2 CHAPTER 11 | Long-Run Economic Growth: Sources and Policies

Estimated Real GDP for the United States

for Various Growth Rates

1.3% 2.3% 3.3%

1930 $1,069.3 billion $1,079.9 billion $1,090.4 billion

The differences in estimated real GDP for 1930 seem small, but how different would GDP be if these
growth rates continued through 2016?

Estimate real GDP for the United States if the economy grew from 1930 to 2016 at three different growth
rates: (a) 1.3 percent annually, (b) 2.3 percent annually, and (c) 3.3 percent annually.

Source: U.S. Bureau of Economic Analysis. http://www.bea.gov/

Solving the Problem

Step 1: Review the chapter material.
This problem is about the importance of economic growth over time, so you may want to
review the section “Economic Growth over Time and around the World,” which begins on
page 738 in the textbook.

Step 2: Estimate real GDP for the United States if the economy grew from 1930 to 2016
at three different growth rates: (a) 1.3 percent, (b) 2.3 percent, and (c) 3.3
percent.
The table below shows what real GDP would be in 2016 if real GDP grew at the three different
rates.
Estimated Real GDP for the United States
for Various Growth Rates

1.3% 2.3% 3.3%

2016 $3,205.6 billion $7,461.1 billion $17,223.7 billion

The estimated value for real GDP using a 3.3 percent growth rate is more than twice the
estimated value for real GDP assuming a growth rate of 2.3 percent, and more than five times
the estimated real GDP assuming a 1.3 percent rate of growth. These calculations show how
apparently small differences in growth rates, compounded for 87 years, can result in very
different amounts of real GDP. (The actual real GDP for 2016 was $16,716.2. This figure will
be revised as more data become available.)

What Determines How Fast Economies Grow? (pages 359–366)

11.2 Learning Objective: Use the economic growth model to explain why growth rates
differ across countries.

The economic growth model explains growth rates in real GDP per capita over the long run. This model
focuses on the causes of long-run increases in labor productivity, which is the quantity of goods and
services that can be produced by one worker or by one hour of work. Economists believe that two key
factors determine labor productivity: the quantity of capital per hour worked and the level of technology.

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 CHAPTER 11 | Long-Run Economic Growth: Sources and Policies 3

Technological change is a change in the quantity of output a firm can produce using a given quantity of
inputs. There are three main sources of technological change:
1. Better machinery and equipment.
2. Increases in human capital, which is the accumulated knowledge and skills that workers acquire
from education and training or from their life experiences.
3. Better means of organizing and managing production.

A country’s standard of living will be higher the more capital workers have available on their jobs, the
better the capital, the more human capital workers have, and the better the job business managers do in
organizing production.

A. The Per-Worker Production Function

The economic growth model can be illustrated by using the per-worker production function, the
relationship between real GDP per hour worked and capital per hour worked, holding the level of
technology constant. Increases in the quantity of capital per hour worked result in movements up along
the per-worker production function. Holding technology constant, equal increases in the amount of capital
per hour worked lead to diminishing increases in output per hour worked.

B. Which Is More Important for Economic Growth: More Capital or

Technological Change?
Technological change helps economies avoid diminishing returns to capital.

C. Technological Change: The Key to Sustaining Economic Growth

Technological change shifts up the per-worker production function and allows an economy to produce
more real output per hour worked with the same quantity of capital per hour worked. In the long run, a
country will experience an increasing standard of living only if it experiences continuing technological
change.

D. New Growth Theory

New growth theory is a model of long-run economic growth which emphasizes that technological
change is influenced by economic incentives and so is determined by the working of the market system.
Paul Romer, who developed the new growth theory, argues that the rate of technological change is
influenced by how individuals and firms respond to economic incentives. Firms add to an economy’s
stock of knowledge capital when they engage in research and development or otherwise contribute to
technological change. Romer argues that the accumulation of knowledge capital is subject to diminishing
returns at the firm level, but at the level of the entire economy, knowledge capital is subject to increasing
returns.

The use of knowledge capital is nonrival because one firm’s use of that knowledge does not prevent
another firm from using it. Romer points out that firms are unlikely to engage in research and
development up to the point where the marginal cost of the research equals the marginal return from the
knowledge gained because other firms will gain much of the marginal return. Government policy can
increase the accumulation of knowledge capital in three ways:
1. Protecting intellectual property with patents and copyrights. A patent is the exclusive right to
produce a product for a period of twenty years from the date the patent application is filed with
the government.
2. Suupporting research and development.

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4 CHAPTER 11 | Long-Run Economic Growth: Sources and Policies

3. Subsidizing education.

These policies can bring the accumulation of knowledge capital closer to the optimal level.

E. Joseph Schumpeter and Creative Destruction

The new growth theory has revived interest in the ideas of Joseph Schumpeter, who developed a model of
growth that emphasized his view that new products drive older products—and the firms that produce
them—out of the market. For Schumpeter, the key to rising living standards is the development of new
products that meet consumer needs in qualitatively different ways. Successful entrepreneurs can use their
profits to finance the development of new products.

11.3 Economic Growth in the United States (pages 366–369)

Learning Objective: Discuss fluctuations in productivity growth in the United States.

The economic growth model can help us understand the record of growth in the United States.

A. Economic Growth in the United States since 1950

Productivity in the United States grew rapidly from the end of World War II until the mid-1970s. Growth
then slowed down for 20 years. Beginning in the mid-1990s, the growth rate picked up again, but
beginning in 2006, growth slowed once more.

B. Is the United States Headed for a Long Period of Slow Growth?

Some economists argue that productivity has become more difficult to measure and that the United States
is likely to experience high rates of growth in the long run. Other economists believe that productivity
entered a long-run decline in the mid-1970s that was only briefly overcome by the effects of the
revolution in information technology (IT).
Some economists argue that the development of information technology caused the higher rate of growth
of productivity in the 1990s. Those who believe that IT is having large, but difficult to measure, effects on
the economy are optimistic about future growth rates and that advances in semiconductor technology will
result in substantial gains in labor productivity. Other economists doubt that the unmeasured gains from
the IT revolution are greater than the unmeasured gains from previous innovations. And some economists
believe that insufficient demand for investment spending will result in secular stagnation. Those who
subscribe to the secular stagnation scenario claim that the demand for loanable funds will be low because:
1. Slowing population growth will reduce the demand for housing.
2. Modern information technology firms will require less capital than older firms.
3. The price of capital has been falling relative to the prices of other goods. Firms can meet their
capital needs with lower expenditures.

Extra Solved Problem 11.3

U.S. Productivity Growth and Employment
The textbook describes the productivity slowdown from 1974 to 1995 in which the annual growth rate of
real GDP per hour worked in the United States was 1 percentage point per year lower than during the
1950–1973 period. Although the reasons for this anemic growth are still not certain, the subsequent
increase in productivity growth from 1996 to 2006 was welcome news to economists. But others have
pointed to a dark lining in this silver cloud. The economic expansion that began after the 2001 recession

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 CHAPTER 11 | Long-Run Economic Growth: Sources and Policies 5

was frequently referred to as a “jobless recovery” in newspaper and magazine articles. Some observers
argued that faster productivity growth allowed employers to increase production without increasing
employment. Although employment growth subsequently increased, the concern expressed for workers’
jobs highlights two different views of productivity. In the Federal Reserve Bank of San Francisco’s
Economic Letter, Carl Walsh wrote:
If higher productivity allows firms to shed workers, how can it raise wages and living
standards? If productivity does lead to improved wages and living standards, why do so many
feel the recent productivity growth has left workers behind?
Walsh notes that productivity growth and changes in technology cause structural changes that result in
increased production and employment in some industries and reductions in production and employment in
other industries. For example, the growth in demand for word processors and personal computers resulted
in a decline in the demand for typewriters and some types of office workers. Small changes in overall
employment mask what often are large increases in employment and unemployment in individual
industries. In other words, the negative effect of productivity on employment occurs in the short run,
while the positive effect of productivity on employment occurs in the long run.
Source: Carl E. Walsh, “The Productivity and Jobs Connection: The Long and the Short of It.” FRBSF Economic Letter. July 16,
2004.

The average annual growth rate of real GDP per hour worked from 1950 to 1973 was 2.6 percent.
Examine the fluctuations in the annual unemployment rate for this period in Figure 20.5 in the textbook.
Is the behavior of the unemployment rate consistent with Carl Walsh’s explanation of the effect of
productivity growth on employment?

Solving the Problem

Step 1: Review the chapter material.
This problem is about fluctuations in productivity growth, so you may want to review the
section “Economic Growth in the United States,” which begins on page 750 in the textbook.

Step 2: Is the behavior of the unemployment rate consistent with Carl Walsh’s
explanation of the effect of productivity growth on employment?
Yes, Walsh’s explanation is consistent with the behavior of unemployment. Despite the
relatively large increases in productivity from 1950 to 1973, the rate of unemployment did
not have an upward trend. Most of the fluctuation in the unemployment rate occurred as a
result of business cycle fluctuations. This observation is consistent with the argument that
increases in productivity lead to increased employment in the long run by raising the real
wage workers receive. Other data are needed to show how much total employment changed
and which industries experienced job gains and job losses.

Extra
Productivity Gains Help Make U.S. Manufacturers More
Apply the
Competitive
Concept

It’s a story all too familiar to many Americans: Caterpillar, the world’s largest manufacturer of
construction and industrial mining equipment, tried to persuade workers at one of the company’s
locomotive assembly plants to accept lower wages in order to reduce its wage and benefit costs, which
were much higher than they were at a Caterpillar plant in another country. What was different about the
story was the location of the two plants: Wage and benefit costs at Caterpillar’s rail-equipment plant in

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6 CHAPTER 11 | Long-Run Economic Growth: Sources and Policies

LaGrange, Illinois, were less than half of those at the company’s locomotive-assembly plant in Ontario,
Canada. Navistar International Corp., formerly the International Harvester Company, manufactures diesel
engines, buses, and other business equipment. Navistar also sought to lower costs at its plant in Ontario.
After failing to reach an acceptable agreement for more-flexible work rules and lower wage costs with the
Canadian Auto Workers, the company decided to relocate the plant to Springfield, Ohio. Navistar’s Chief
Executive Dan Ustian commented: “I am a firm believer that North America and the United States can be
very competitive in manufacturing, especially when it is a technical kind of job.” Bridgestone Corp. of
Japan spent over $1 billion to expand a plant in South Carolina that makes radial tires. Gary Garfield,
CEO of Bridgestone’s Americas unit, explained that the higher productivity of U.S. workers trumped
lower labor costs in other potential plant locations in Mexico or Latin America.

What has made U.S. manufacturers more efficient and more competitive in recent years? The recession of
2007–2009 slowed the growth of wages and many firms have incorporated flexible work practices and
increased automation in order to increase productivity. As a result, labor costs actually decreased by 13
percent among U.S. manufacturers from 2000 to 2010. Over this same period, unit labor costs rose in
Germany (by 2.3 percent), in Canada (by 18 percent), and in South Korea (by 15 percent). Other factors
that contributed to holding down U.S. manufacturing costs include lower energy prices, due mostly to
increased production of natural gas from shale, and a lower exchange rate for the dollar.

Sources: James R. Haberty and Kate Linebaugh, “In U.S., a Cheaper Labor Pool,” Wall Street Journal, January 6, 2012; and Erik
Brynjolfsson, “Not All the Economic News is Bad,” digitopoly.org, October 27, 2011.

Why Isn’t the Whole World Rich? (pages 369–378)

11.4 Learning Objective: Explain economic catch-up and discuss why many poor countries
have not experienced rapid economic growth.
The economic growth model tells us that economies grow when the quantity of capital per hour worked
increases and when technological change takes place. The profitability of using additional capital or better
technology is generally greater in a developing country than in a high-income country. The economic
growth model predicts that poor countries will grow faster than rich countries. Catch-up is the prediction
that the level of GDP per capita (or income per capita) in poor countries will grow faster than in rich
countries. The paradox is that lower-income industrial countries have been catching up to the higher-
income industrial countries, but the developing countries as a group have not been catching up to the
high-income countries as a group.

A. Catch-up: Sometimes but Not Always

A graph can be used to illustrate whether catch-up is happening. The initial level of GDP per capita is
measured along the horizontal axis and the vertical axis shows the rate at which GDP per capita is
growing. Low-income countries should be in the upper-left part of the graph and high-income countries
should be in the lower-right part of the graph. Some countries that had low levels of real GDP per capita
in 1960 had lower levels of real GDP per capita in 2014 than in 1960. Other countries that started with
low levels of real GDP per capita grew rapidly.

B. Why Haven’t Most Western European Countries, Canada, and Japan Caught Up
to the United States?
Over the past twenty years, other high-income countries have fallen further behind the United States. Real
GDP per capita in Canada, Japan, and the five largest countries in Western Europe increased relative to the
United States between 1960 and 1990, but none of these countries has experienced catch-up since 1990.
Many economists believe there are two explanations for the failure of these countries to catch-up with the
United States: The greater flexibility of U.S. labor markets and the greater efficiency of the U.S. financial
system.

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 CHAPTER 11 | Long-Run Economic Growth: Sources and Policies 7

C. Why Don’t More Low-Income Countries Experience Rapid Growth?

Many poor countries do not experience rapid growth for four main reasons:
 Failure to enforce the rule of law, which is the ability of a government to enforce the laws of the
country, particularly with respect to protecting private property and enforcing contracts
 Wars and revolutions
 Poor public education and health
 Low rates of saving and investment

Property rights are the rights individuals or firms have to the exclusive use of their property, including
the right to buy or sell it.

D. The Benefits of Globalization

One way for a developing country to break out of the vicious cycle of low saving and investment and low
growth is through foreign investment. Foreign direct investment (FDI) is the purchase or building by a
firm of a facility in a foreign country. Foreign portfolio investment is the purchase by an individual or a
firm of stocks or bonds issued in another country. Globalization is the process of countries becoming
more open to foreign trade and investment. Developing countries that are more globalized have grown
faster than countries that are less globalized.

11.5 Growth Policies (pages 379–383)

Learning Objective: Discuss government policies that foster economic growth.

A. Enhancing Property Rights and the Rule of Law

A market system cannot work well unless property rights are enforced. Entrepreneurs are unlikely to risk
their own funds, and investors are unlikely to lend their funds to entrepreneurs, unless property is safe
from being arbitrarily seized. In many developing countries, the rule of law and property rights are
undermined by corruption. Research has shown that countries where corruption is most widespread grow
much more slowly than countries where corruption is less of a problem.

B. Improving Health and Education

As people’s health improves and they became taller, stronger, and less susceptible to disease, they also
become more productive. Many economists believe that government subsidies to education have played
an important role in promoting economic growth. The rising incomes that result from economic growth
can help developing countries deal with brain drain. Brain drain refers to highly educated and successful
individuals leaving developing countries for high-income countries.

C. Policies That Promote Technological Change

Government policies that facilitate access to technology are crucial for low-income countries. The easiest
way for developing countries to gain access to technology is through foreign direct investment. In high-
income countries, government policies can aid the growth of technology by subsidizing research and
development.

D. Policies That Promote Saving and Investment

Governments can increase incentives for firms to engage in investment in physical capital by using
investment tax credits. These credits allow firms to deduct from their taxes some fraction of the funds
they have spent on investment.

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8 CHAPTER 11 | Long-Run Economic Growth: Sources and Policies

E. Is Economic Growth Good or Bad?

The arguments against further economic growth tend to be motivated either by concern about the effects
of growth on the environment or by concern about the effects of the globalization process that has
accompanied economic growth in recent years. Economic analysis can contribute to the debate over the
consequences of economic growth, but it cannot resolve the issue.

Teaching Tips
The following graph shows that developing countries that were more open to foreign trade and investment
grew much faster during the 1990s than developing countries that were less open.

Globalization and Growth

Source: David Dollar, “Globalization, Inequality, and Poverty since 1980,” World Bank Research Observer, Vol. 20, No. 2, Fall
2005, pp. 145–175.

Extra Solved Problem 11.5

What Is the Proper Role for Government in Promoting Growth?
One popular explanation for the persistent poverty of developing nations is a lack of natural resources.
But Hong Kong and Japan, with meager supplies of natural resources, experienced more rapid economic
growth in recent decades than some nations that have more abundant supplies of resources. Economist
Paul Romer has argued that it is ideas, not natural resources, that poor countries lack most: “If a poor
nation invests in education and does not destroy the incentives for its citizens to acquire ideas from the
rest of the world, it can rapidly take advantage of the publicly available part of… knowledge.”
In the United States and other developed countries, most economists support three government policies
that encourage the production and dissemination of new knowledge:
 Subsidies for education
 Competitive grants for basic research
 Patents and copyrights

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 CHAPTER 11 | Long-Run Economic Growth: Sources and Policies 9

Romer warns that it is important to limit government’s power over economic policy. He states that most
economists favor government subsidies for education and private research, but if government officials
have power over economic policy, they may use that power to divert the results of research to narrow
special interests.
Source: Paul M. Romer, “Economic Growth,” The Concise Encyclopedia of Economics.
http://www.econlib.org/library/Enc/EconomicGrowth.html

a. Why do economists believe that government should subsidize education and basic research?
b. Paul Romer warns that government officials may use their power to divert the results of research
to narrow special interests. Explain Romer’s concern.

Solving the Problem

Step 1: Review the chapter material.
This problem is about policies that can foster economic growth, so you may want to review
the section “Growth Policies,” which begins on page 763 in the textbook.

Step 2: Explain why economists believe that government should subsidize education and
basic research.
Private firms have little incentive to invest in activities that, if successful, are not profitable.
The social returns to investment in education and basic research are significant, but these
returns are spread throughout the economy. Therefore, firms may not undertake research that
would increase economic growth and benefit the whole economy because the research would
not be profitable for them. A government subsidy may be necessary to provide firms with the
incentive to invest in basic research.

Step 3: Explain Paul Romer’s concern that government officials may use their power to
divert the results of research to narrow special interests.
Elected officials are likely to favor projects that are located in their own states or districts
rather than projects that have the greatest social returns. For example, politicians from Iowa
are apt to favor subsidies for the use of ethanol as a source of energy because the subsidy
benefits corn farmers in their state.

Extra
The Role of Local Government in Promoting Economic Growth
Apply the
in China
Concept

Economic growth in China has been among the highest of any nation, often exceeding 7 to 9 percent
annually since 1979. A key to achieving economic growth in a market economy is protection of rights to
private property. However, China has a relatively weak judicial system and a poor property rights
environment. An explanation for China’s success in attracting private investment despite a poor track
record in protecting property rights is offered by X. Zhang, who argues that local Chinese governments
engage in vigorous competition for investment that benefits their own jurisdictions. The uncertainty of
doing business is very high and, as a result, the cost of completing contracts is high as well. To overcome
these obstacles, businesses often partner with local government officials who work hard to provide a
stable environment for these businesses and provide protection from local government regulations. The
result is strong protection for investors within a weak system of protection of property rights for rural

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10 CHAPTER 11 | Long-Run Economic Growth: Sources and Policies

landowners. Farmers and other Chinese citizens are often forced to sell their rights to land for allegedly
“public purposes”—that is, for new private businesses. Although this system has produced considerable
prosperity for China, it has come at the expense of increased social tension, especially among current and
former landowners. It may be difficult to sustain China’s high rate of economic growth far into the future
without addressing this potential source of social conflict.

Source: Karol Boudreaux and Paul Dragos Aligica, “Legislation and creation by fiat,” in Paths to Property (London: The
Institute of Economic Affairs, 2007), pp. 65–66.

Extra Economics in Your Life & Career:

Can Economic Growth in China Have an Impact on You?

Question: China has enjoyed higher economic growth for the last decade than has the United States. How
can China’s rapid economic growth affect your welfare (assuming you live in the United States)?

Answer: The fact that China is experiencing rapid economic growth allows firms located in China to
manufacture more products at a lower cost. So, consumers in the United States are able to buy lower-
priced imports from China, while growing prosperity in China will encourage consumers and firms to buy
more products from other countries, including the United States. Some firms and workers in the United
States will be made worse off if these firms close as a result of competition from Chinese firms.

Extra AN INSIDE LOOK News Article to Use in Class

Visit www.myeconlab.com for current An Inside Look news articles.

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